Friday, April 30, 2004

According to an old (possibly apocryphal) story, economist Armen Alchian was once asked the following question: “If you could wave a magic wand and eliminate all of the pollution in South Central Los Angeles, would you do it?” To which Alchian allegedly replied, “No. It would be cruel to raise those people’s rent like that.”

I usually tell that story to my students just to jolt them into thinking differently (that is, like an economist) about environmental issues. But lately I’ve been wondering if Alchian’s comment might be even more insightful than I’d realized. Environmentalists sometimes get lathered up about “environmental injustice” or “discriminatory pollution,” meaning the location of pollution in regions populated by poor people and minorities. If we take Alchian’s point seriously, the problem is bogus, because the market rental rate for apartments and homes in the affected regions falls enough to reflect the undesirable effects of pollution. And taking the argument one step further, what this means is that the real victims of pollution are not the residents, but the land owners who get paid lower rents. The value of their land diminishes.

But taking the argument yet another step, perhaps even the current land owners are not the real victims, so long as the pollution has been around for a while. Consider the analogy to a property tax. A property tax reduces the value of the property, because the owner is obligated to pay a stream of future taxes. When the tax is imposed for the first time, the current owner suffers a reduction in the price for which he can sell his land, because it’s now burdened with a tax liability that is capitalized into the land’s value. But if he sells the land to a new owner, the new owner does not take a hit, because the tax liability is reflected in the lower price. Yes, it appears that the new owner suffers, because he must pay property taxes – but if not for the taxes, he would have paid a higher price for the property. The price differential should be approximately equal to the present discounted value of the stream of tax payments. In effect, a property tax is borne entirely by the land owner at the time of the tax’s imposition.

The analogy to pollution should be clear. If there is an increase in pollution in a particular region, and that increase is expected to be permanent, then the cost of the pollution gets capitalized into the land value. The owner at the time of the pollution increase suffers, but subsequent owners do not, because they are compensated by the lower sale price. Subsequent owners suffer new damage only from further increases in the pollution burden. Renters suffer damages during the period in which their rent remains at the level set prior to the increase in pollution.

I haven’t worked all the way through the logic, but my suspicion is that these considerations don’t really change the economist’s prescriptions for how to deal with externality problems. For most economists, the key question is whether the gains from the polluting activity are greater than the reduction in value of all the affected land. A policy allowing current owners or renters to sue for damages might (and I emphasize might, because I’m leaving out a lot of relevant caveats) internalize the externality and produce the efficient outcome. But interestingly, my analysis above indicates that this policy would be awarding damages to people who may not have suffered any actual (uncompensated) harm. On the other hand, if such a policy already existed at the time of the purchase of the land, that, too, would be capitalized into the sale price – this time by raising it. The higher price would be compensated by the expectation of a future legal settlement.

If there’s a policy implication of my speculation here, I think it probably comes down to this: In the absence of substantial administrative costs, the following two policies would have equivalent effects: (a) a policy that allows current owners and renters to sue for damages from new or existing pollution, and (b) a policy that allows only owners at the time of a permanent increase in pollution to sue for damages from pollution. But in the presence of administrative costs, (a) would involve lawsuits every year, whereas (b) would allow all lawsuits to be handled just once, thereby minimizing administrative costs. On the other hand, (a) and (b) might only be equivalent when the benefits and costs from the polluting activity are relatively constant over time, thus assuring that pollution that’s efficient when it first appears continues to be efficient thereafter. If the costs and benefit change substantially over time, (a) might handle better the need for change in pollution levels.